Principles of
Finance
The Time Value of
Money
(Part 2)
4 2
You are an auto dealer you have two choice to sell a car take
$14,000 cash now, or receive three payments: $2,000 now
and $3,000 at the end of the first year $4,000 at the end of
second year and $5,000 at the end of third year. If interest rate
of money you can earn is 5%, which deal do you prefer?
4 3
Topics Covered
Annuity Due
Perpetuity أبدية
Applications
4 5
Annuity
Question Answer
Annuity ???
A series of equal cash flows at regular
interval across time is an annuity.
Brain Test
Equal Car Installments Yes
Electricity bill No
House rent monthly Yes
Monthly Gas bill No
FV $3400 (1 .05) 5
$4339
4 9
The formula for calculating the future value of an ordinary annuity stream is as
follows:
FV = CF X (1+r)n  1
r
FVIFA
4 10
Jill has been faithfully depositing $2,000 at the end of each year since the
past 10 years into an account that pays 8% per year. How much money
will she have accumulated in the account?
Use Formula
FV=$2000*[((1.08)^10  1)/.08]
= $28,973.13
Use Table
FV=$2000*14.4866
= $28,973.13
4 11
=$148,268.76
4 14
C1 C2
PV (1 r ) 1
(1 r ) 2 ....
4 16
1
1 n
1 r
PV PMT
r
1
1 PVIFA
1 r
n
1
1 n
1 r
PV PMT
r
4 19
PV of Perpetuity Formula
PMT
PV r
100 , 000
PV .10 $1,000,000
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4 21
1, 000 , 000
PV (1 .10 ) 3
$751,315
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4 22
Example: Annuity
You are purchasing a car. You are scheduled to
make 3 annual installments of $4,000 per year.
Given a rate of interest of 10%, what is the price you
are paying for the car (i.e. what is the PV)?
1
1 n
1 r
PV PMT
r
PV 4 ,000 1
.10
1
.10 ( 1 .10 ) 3
PV $9,947.41
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4 23
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4 24
Under which of the three options will Abdullah pay the least interest and
why? Calculate the total amount of the payments and the amount of interest
paid under each alternative.
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4 25
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4 27
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4 29
Amortization Schedules
Example: Loan amortization schedule.
Prepare a loan amortization schedule for the
amortized loan option given in example above.
What is the loan payoff amount at the end of 2
years?
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4 30
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4 31
Topics Covered
Problems
&
Cases
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4 32
Problem
QSam Hinds, a local dentist, is going to remodel the dental
reception area and two new workstations. He has contacted
IKEA, and the new equipment and cabinetry will cost $18,000.
IKEA will finance the equipment purchase at 7.5% over a six
year period of time. What will Hinds have to pay in annual
payments for this equipment?
1
1 n
1 r
PV PMT
r
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4 33
Problem
QThe Stack has just written and recorded the single
greatest rock song ever made. The boys in the band believe
that the royalties from this song will pay the band a
handsome $200,000 every year forever. The record studio is
also convinced that the song will be a smash hit and that the
royalty estimate is accurate. The record studio wants to pay
the band upfront and not make any more payments for the
song. What should the record company offer the band if
they use
5% discount rate,
7.5% discount rate, or
10% discount rate?
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4 34
Problem
County Ranch Insurance Company wants to offer a
guaranteed annuity in units of $500, payable at the end of
each year for twentyfive years. The company has a strong
investment record and can consistently earn 7% on its
investments after taxes. If the company wants to make 1%
on this contract, what price should it set on it? Assume
that it is an ordinary annuity and that the price is the same
as present value.
(Use 6% as the discount rate)
4 35
Case 1
QWhat is the difference between a
series of payments and an annuity?
What are the two specific
characteristics of a series of payments
that make them an annuity?
Answer
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4 36
Case 2
Q What effect on the future value of an

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4 37
Case 3
Q What
 effect on the present value of an annuity does
increasing the interest rate have? Does a decrease from 7%
to 5% have the same dollar impact as a decrease from 5% to
3%?
Answer
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4 38
Case 4
QIs the present value always less than the
future value???
Answer
4 39
Topics Covered
Problems
&
Cases
4 40
MCQ Problem
If a perpetuity is worth $1,000 and rate
is 15.5%, what is the cash flow?
a. $155
b. $157
c. $150
d. $160
4 41
MCQ Problem
The value of a payment, if the payment were made at
some point in the future is called the
MCQ Problem
An investor deposits £600 in a bank and plans to leave
it there for four years. The value of the account after
four years if it earns 10 percent interest compounded
annually will be £
a. £ 856.78
b. £ 878.46
c. £ 915.34
d. £ 934.23
e. £ 978.99
4 43
MCQ Problem
Which equation represents the general relationship
between future values and present values
a. FV = PV(1+r)^n
b. PV= FV(1+r) ^n
d. PV=FV(1xr) ^n
e. FV=PV(1xr) ^n
4 44
MCQ Problem
A (an) ............ is a finite series of equal cash flows
made at regular intervals.
a. IRA
b. Annuity
c. Perpetuity
d. Annual regularity
4 45
MCQ Problem
An annuity with the first cash flow occurring
immediately is called a(n)
a. First annuity
b. Cash annuity
c. Simple annuity
d. Annuity due
4 46
MCQ Problem
If one speaks of an annuity without any qualification,
a(n) ……….. is being discussed
a. First annuity
b. Cash annuity
c. Simple annuity
d. Annuity due
4 47
MCQ Problem
Calculate the present value of an annuity of $100 for
two periods with a 12% rate of interest
a. $ 88.59
b. $100.45
c. $123.90
d. $ 169.05
4 48
MCQ Problem
Calculate the present value factor for a fiveperiod
annuity with an interest rate of 12% per period
a. 1.2008
b. 2.6554
c. 3.6048
d. 4.7665
4 49
MCQ Problem
The present value of a perpetuity is given by
a. PV= r/C
b. PV= CF/r
c. PV= C x r
d. PV = C/ (1+r)